A-Rod’s Option Strike Count

By David Gaffen

Peter A. McKay breaks down just how A-Rod’s big deal would probably have worked out had it been an options contract.

No wonder baseball superstar Alex Rodriguez turned to Wall Street bigwigs for advice when his contract negotiations got dicey. In many respects, the situation was akin to something financial pros deal with all the time: an options trade.

Despite the likelihood A-Rod will soon sign a record-breaking $275 million contract, the trade might not have worked out as well as you think.

Quibbling over a few million bucks for a guy with a .258 lifetime postseason batting average. (AP Photo)

To understand why, start with the reason that Mr. Rodriguez, who has played the last four seasons for the New York Yankees, was negotiating a new contract in the first place. Unlike most players who play to the end of one contract and then look for another, Mr. Rodriguez had an additional three years and more than $70 million due to him under his existing contract when baseball season ended in October. He also had the right, but not the obligation, to forgo those terms and put himself back on the open market as a free agent.

That right to declare free agency resembled a bullish call option on Mr. Rodriguez’s considerable baseball-playing abilities. It had a value, or premium, attached to it even if Mr. Rodriguez didn’t actually become a free agent.

Merely by signaling that he might be willing to give up one big pile of money in order to get an even bigger pile of money, Mr. Rodriguez was effectively exercising his call option. That is to say, the prospect of losing such a productive player effectively forced the hand of his call option’s counterparty – the Yankees – to deliver the larger pile of cash.

In the public markets for options on stocks, commodities and other assets, exercising such a right wouldn’t be a big deal. Aside from the premium on the options themselves, the assets underlying most listed options contracts also trade on exchanges, so everyone can readily see the correct prices to reconcile their trades.

But when the asset underlying an option is a ballplayer, things aren’t so easy.

The Yankees effectively named the compensation they thought was reasonable to deliver against Mr. Rodriguez’s call option. Although the two sides never met in person until later, early leaks to New York-area sportswriters indicated that the Yankees were willing to offer Mr. Rodriguez a contract extension. Including the money he was already guaranteed under his existing contract, the deal would bag him more than $240 million over eight years.

Mr. Rodriguez and his agent, Scott Boras, thought the call option was worth far more upon exercise, between $350 million and $400 million, according to the New York Daily News.

In Wall Street’s options markets, this would be called a failure to deliver or a busted trade. Such disputes are rare and require a regulator like an exchange or the National Association of Securities Dealers to step in to impartially determine what each side is due.

In the A-Rod options market, there were no such middlemen available. Everyone just threw a hissy fit. A-Rod declared free agency to seek a whole new contract. The Yankees refused to start over from scratch and cut off negotiations.

At that point, Mr. Rodriguez sought the advice of billionaire Warren Buffett and Goldman Sachs executives and approached the Yankees without Mr. Boras. (You might say this is the equivalent of an investor ditching his broker, but that’s a whole other matter.) The two sides now seem close to a deal guaranteeing Mr. Rodriguez $275 million over ten years – closer to the Yankees’ original bid than A-Rod’s back-of-the-envelope ask.

The exercise of the original call option has indeed paid off. But was all the acrimony worth it, considering that the Yankees only raised their original bid about 15% — a relatively paltry gap in the world of baseball contracts that the sides probably could’ve closed if they’d just negotiated for an extension from the start? For an athlete like Mr. Rodriguez, who already had a love-hate relationship with the Yankee faithful, you have to wonder.

Comments (3 of 3)

i still am confused as to why the yankees are making a higher offer...i would have this call option expire and have it re-priced at a lower price...probably in the range of $25 mill...i find it highly doubtful other would bid up this price...so why are the yankees bidding against themselves?

5:07 pm November 19, 2007

learningtheropes wrote :

i'm in the process of trying to understand options & trying to understand baseball, and this story helped me better understand both ;-)

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